Friday, April 06, 2007

Bruce Bartlett says we're all supply-siders now, but as explained in some
detail below, I don't fully agree:

How
Supply-Side Economics Trickled Down, by Bruce Bartlett, Commentary, NY Times:
As one who was present at the creation of “supply-side economics” back in the
1970s, I think it is long past time that the phrase be put to rest. It did its
job, creating a new consensus among economists on how to look at the national
economy. But today it has become a frequently misleading and meaningless
buzzword that gets in the way of good economic policy.

Today, supply-side economics has become associated with an obsession for
cutting taxes under any and all circumstances. No longer do its advocates in
Congress and elsewhere confine themselves to cutting marginal tax rates — the
tax on each additional dollar earned — as the original supply-siders did.
Rather, they support even the most gimmicky, economically dubious tax cuts with
the same intensity.

The original supply-siders suggested that some tax cuts, under very special
circumstances, might actually raise federal revenues. For example, cutting the
capital gains tax rate might induce an unlocking effect that would cause more
gains to be realized, thus causing more taxes to be paid on such gains even at a
lower rate.

But today it is common to hear tax cutters claim, implausibly, that all tax
cuts raise revenue. Last year, President Bush said, “You cut taxes and the tax
revenues increase.” Senator John McCain told National Review magazine last month
that “tax cuts, starting with Kennedy, as we all know, increase revenues.” Last
week, Steve Forbes endorsed Rudolph Giuliani for the White House, saying, “He’s
seen the results of supply-side economics firsthand — higher revenues from lower
taxes.”

This is a simplification of what supply-side economics was all about, and it
threatens to undermine the enormous gains that have been made in economic theory
and policy over the last 30 years. Perhaps the best way of preventing that from
happening is to kill the phrase “supply-side economics” and give it a decent
burial.

It’s important to remember that at the time supply-side economics came into
being, Keynesian economics dominated macroeconomic thinking and economic policy
in Washington. Among the beliefs held by the Keynesians of that era were these:
budget deficits stimulate economic growth; the means by which the government
raises revenue is essentially irrelevant economically; government spending and
tax cuts affect the economy in exactly the same way through their impact on
aggregate spending; personal savings is bad for economic growth; monetary policy
is impotent; and inflation is caused by low unemployment, among other things.

These beliefs led to many bad economic policies. In particular, they lay at
the root of stagflation, that awful combination of high inflation and slow
growth that bedeviled policy makers in the 1970s. Based on insights derived from
the Nobel-winning economists Robert Mundell, Milton Friedman, James Buchanan and
Friedrich Hayek, the supply-siders developed a new program based on tight money
to stop inflation and cuts in marginal tax rates to stimulate growth.

As the staff economist for Representative Jack Kemp, a Republican of New
York, I helped devise the tax plan he co-sponsored with Senator William Roth, a
Delaware Republican. Kemp-Roth was intended to bring down the top statutory
federal income tax rate to 50 percent from 70 percent and the bottom rate to 10
percent from 14 percent. We modeled this proposal on the Kennedy-Johnson tax cut
of 1964, which lowered the top rate to 70 percent from 91 percent and the bottom
rate to 14 percent from 20 percent.

We believed that our tax plan would stimulate the economy to such a degree
that the federal government would not lose $1 of revenue for every $1 of tax
cut. Studies of the 1964 tax cut showed that about a third of it was recouped,
and we expected similar results. Thus, contrary to common belief, neither Jack
Kemp nor William Roth nor Ronald Reagan ever said that there would be no revenue
loss associated with an across-the-board cut in tax rates. We just thought it
wouldn’t lose as much revenue as predicted by the standard revenue forecasting
models, which were based on Keynesian principles.

Furthermore, our belief that we might get back a third of the revenue loss
was always a long-run proposition. Even the most rabid supply-sider knew we
would lose $1 of revenue for $1 of tax cut in the short term, because it took
time for incentives to work and for people to change their behavior. ...

Moreover, we were adamant that only permanent cuts in marginal tax rates
would stimulate the economy. We thought that temporary tax cuts, tax rebates,
tax credits and such were economically worthless, and we strongly opposed them.

Today, hardly any economist believes what the Keynesians believed in the
1970s and most accept the basic ideas of supply-side economics — that incentives
matter, that high tax rates are bad for growth, and that inflation is
fundamentally a monetary phenomenon. Consequently, there is no longer any
meaningful difference between supply-side economics and mainstream economics.

There is no question in my mind that we never could have overcome the
stagflation of the 1970s as quickly or with as little pain as we did without the
supply-side idea. But supply-side economics has done its job, just as Keynesian
economics did in the 1930s. Those who campaign as its champions are fighting a
fight long won — and it is time for supply-side rhetoric to go, with its
essential truths embodied in mainstream economics and its perversions discarded
for good.

As noted above, I don't fully agree, so let me cast this debate in a
different framework where it's easier for me to highlight where we differ.

Let's start with the following fairly standard picture of the evolution of
GDP. The red line shows actual output cycling over time, and the blue
line shows that natural rate of output which also varies over time:

As depicted, the natural rate is subject to both permanent and temporary
supply shocks causing growth to be uneven, but generally upward, and actual
output is driven away from the natural rate by demand shocks. That is, the
variation in the blue line is from supply-shocks, and the deviation of the red
line from the blue line is from demand shocks.

In general, there are two types of policies to consider. The first is the use of
monetary and fiscal policy to stabilize the economy. The goal here is to use changes in the money
supply, government spending, and taxes to manage aggregate demand and minimize
the deviations of actual output from the natural rate of output. This is shown
by the dotted red line in the following diagram which is closer, on average to
the natural rate than the no-policy outcome shown as the solid red line:

The second type of policy is growth policy. This is what many people mean when they
use the term supply-side policy. The goal here is to increase the growth rate of
output. This is shown by the upward rotation of the trajectory for the natural rate in
the following diagram:

The natural rate of output is determined by the growth of technology, the
growth of the capital stock, and the growth of the labor force so policies to
increase the growth rate of output are directed at these factors. Examples of
supply-side policies are (not all have proven to be equally effective, or
effective at all in some cases, and this is far from exhaustive) tax breaks for research and development (to
increase technology), tax breaks for IRAs (to increase saving, investment, and
the capital stock), tax cuts on capital gains and dividend (to make capital
markets more efficient and increase the capital stock), spending on education
(to make labor more productive), reductions in marginal tax rates (so people
will increase work effort), accelerated depreciation (to make investment cheaper
and increase he capital stock), and reductions in estate taxes (so people will work
harder to leave more for their heirs).

Note also that it is the upward rotation in the supply-curve that generates
the increase in taxes from supply side policies that you often hear about. The
question, of course, is how much additional growth comes from a cut in taxes and
here I agree to some extent with Bruce Bartlett. It depends upon the type of tax
cuts that are enacted, some are more productive than others and hence some types of tax cuts
generate more tax revenue than others. Whether the tax cut is permanent or
temporary is also important.

We'd disagree over the magnitude however.
While some types of tax cuts can affect growth, the effect is nowhere near
large enough to generate a 33% tax revenue recovery rate, not even close, and,
in any case, all the low-hanging fruit has already been plucked, something that
is often overlooked.

That is not the end of our disagreement. Bartlett does not distinguish
between various classes of models, between the short-run and long-run, or
between stabilization and growth policy all of which are important distinctions
so let me touch upon these issues.

There are two predominant views of the source of fluctuations in output, Real
Business Cycle models and New Keynesian models.

Real Business Cycle (RBC) theorists believe that most if not all fluctuations
in the economy are due to supply side shocks, aggregate demand shocks such as
changes in the money supply, changes in taxes, and changes in government
spending affect nominal variables such as prices but have little to do with
changes in output over time (however, government intervention does causes
inefficiencies in these models so that less intervention is generally preferred
to more). Thus, for RBC advocates, the red and blue lines lie nearly on top on
one another because nearly all of the movement in output is due to
supply shocks.

Thus, since short-run demand management is ineffective in these
models (and often counterproductive), all that's left is long-run growth policy and that's why people such as
Bruce Bartlett, who have an RBC model in mind when thinking about policy, tend
to focus on long-run, supply-side, growth enhancing policies.

Let me turn next to Keynesians. My focus is on the New Keynesian (NK) school,
but I should note that I don't agree with all of the characteristics Bartlett
associates with Keynesians of the 1960s and 1970s, and I certainly don't agree
with the claim made in the next paragraph that after the policy failures of the
1970s "the supply-siders developed a new program based on tight money to stop
inflation and cuts in marginal tax rates to stimulate growth." A standard
expectations augmented Phillips curve story does a much better job of explaining
these events, and the interest rate targeting rules used from the early 1980s
onward are not based upon RBC models. Most RBC models don't even include money
as it plays not role in either the short-run or long-run.

New Keynesians (NK) do not deny that shocks to aggregate supply can affect
GDP nor that supply shocks can be large and important. However, New Keynesians
also believe that aggregate demand shocks are important, i.e. that the
difference between the blue and red lines is large.

New Keynesians attempt to stabilize actual output around the natural rate as
shown above. Why does NK policy tend to focus on demand shocks rather than supply shocks? The
answer is that although it would be ideal if we could use supply-side polices to
smooth short-run fluctuations in output arising from supply shocks, the reality is that we cannot
do this.
As Bartlett notes, supply-side polices are very blunt, slow-acting policies that can affect
output in the
long-run, but they are all but useless in dealing with short-run fluctuations in
the economy (thus,
RBC theorists tend to focus mainly long-run growth).

Since supply cannot be managed in the short-run, that leaves demand management policies, i.e. monetary and fiscal policy. As
we learned in the 1970s, demand side tools are not very effective instruments
for offsetting supply-side shocks - trying to use demand side policy to offset supply shocks
helped to generate the stagflation we saw at the time. We've learned since then, but practically we
are still somewhat powerless to offset supply side shocks in the short-run - all
we can do is manage demand to match changes in supply. That is, if a hurricane wipes out supply, we
can use policy to reduce demand to match, but we can't do much to increase
supply back to its initial level in the short-run.

What we can do much more effectively, if you believe in NK models, is stabilize demand shocks through demand management policy. These
policies are relatively simple conceptually, the trick is to manage demand so
that upward and downward demand shocks are offset by appropriate changes in policy, but
that is easier said than done. Still, we do appear to be able to reduce
variation over time through both monetary policy in particular, and also through fiscal policy (e.g. through
automatic stabilizers).

The claim made by Bruce Bartlett that "there is no longer any meaningful difference between
supply-side economics and mainstream economics" is not something I can agree
with. There are big differences between the RBC and NK schools and big
differences in the implications of the two schools for policy in the short-run. RBC advocates do
not believe in short-run stabilization policy, their focus is solely on
maximizing long-run output growth. NK theorists do not deny that robust economic
growth is important, but they also believe that government can play a helpful
role is smoothing short-run economic fluctuations.

Why do Republicans tend to endorse the RBC framework? I believe in many cases
that belief in the RBC model arises from an honest view that the evidence is
most supportive of this class of models. But in other cases I believe it is an
ideological marriage. The RBC model has two features that make it attractive.

First, because it says short-run stabilization policy is ineffective, and
that government intervention through either spending or taxes generates economic
distortions, the RBC framework supports an approach where the role of government
in the economy is minimized.

Second, because the RBC framework allows for tax cuts to produce higher growth by reducing
inefficiencies, and because it is then possible to argue that tax revenues might
increase, it gives two reasons for supporting tax cuts - higher growth and less
than a full loss of tax revenue, i.e. a dollar tax cut does not cost a dollar (or, for serious ideologues, the tax-cuts even
pay for themselves).

The NK model, on the other hand, supports active government intervention
which is at odds with this ideology. In
addition, because the focus in NK models is on stabilization of output around the natural
rate, not on growth of the natural rate, tax-cuts do not
have the dynamic long-run effects as in RBC models (though these can be added)
and hence there is not as much ideological support for tax cuts in the NK framework.

This is much too long already, but a few more things. We don't we know which type of
shock is most important? If demand shocks play a substantial role, we should pay
attention to the NK policy prescriptions, but if aggregate supply shocks are the
primary force behind business cycles, we should abandon short-run stabilization
and focus solely on long-run growth. We don't we just look at the empirical
evidence and figure this out?

The problem, essentially, is that we only have one time-series, GDP, and we
want two things from it, supply shocks and demand shocks. Since we only have one
piece of information and want two things from it, we must make an assumption of
some sort. Under some assumptions, supply shocks appear predominant, but under
others, demand shocks are the most important factor in business cycles. Because
we have no way of knowing for sure which assumption is best, and because the
econometric evidence changes as the assumptions change, we are left with
uncertainty as to which type of shock matters most and hence which model we
ought to prefer.

There is much more to say about all of this, I haven't even mentioned New Classical models, but that will have to do for now. Summarizing, contrary to what is implied in Bruce Bartlett's commentary, there
are two distinct schools in economics, the RBC school and the NK school, and
they have very different policy implications. Not everyone will agree with this, and that is the
point I suppose, but I would argue that the mainstream view today is the NK model, though
the RBC school has strong advocates and has made important contributions to our
thinking (the long-run incentives Bruce Bartlett mentions are a good example).

So, here's where we agree. Both NK and RBC advocates see the long-run
similarly. Both schools agree that demand side polices have little effect on long-run growth. Both agree that incentives matter, and that we should, of course, strive to enhance
efficiency and long-run growth whenever possible. There is a difference in the
two schools as to the strength of those incentives, but if that is all that is
meant by supply-side polices, then fine, no problem, we're in agreement.

But there is a big disagreement over the short-run. RBC adherents take a
hands-off, free market approach. Their model tells them that government
interference causes inefficiencies, and that there is nothing to be gained in
return in terms of enhanced stability. NK adherents believe government
should take an active role in stabilizing the economy and that is something
that, contrary to what is implied above, has not changed since the 1960s and
1970s. The model used by the NK school is very different from the models we used
then - and our approach to policy is similarly different - but the basic idea
that government intervention can help to stabilize output and employment in the
short-run is unaltered.

SUPPLY SIDE CODA....A couple of days ago, after reading the latest tax-cut pandering from Republican presidential candidates, I had a weak moment and got to feeling a little sorry for supply-side economists. The one or two honest ones left, anyway.... [Read More]

Bruce Bartlett and Mark Thoma are having a debate over what New Keynesians and sensible supply-siders have to offer. See the comments at Mark’s place as Paul Krugman has engaged in this debate. While Mark does an excellent job, I have to add something ... [Read More]

Bruce Bartlett wrote a very good piece for the New York Times on what supply side economics was when it started, what it is taken to mean now and how the two meanings have diverged. Mark Thoma picked it up [Read More]

Lawrence White defends Bruce Bartletts characterization of 1970s era keynesianism against the shocked protests of Paul Krugman. I am with Bartlett and White on this one. That being said, mark Thomas discussion, while a bit off Bart... [Read More]

Tracked on Tuesday, April 10, 2007 at 10:00 PM

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Bruce Bartlett: How Supply-Side Economics Trickled Down

Bruce Bartlett says we're all supply-siders now, but as explained in some
detail below, I don't fully agree:

How
Supply-Side Economics Trickled Down, by Bruce Bartlett, Commentary, NY Times:
As one who was present at the creation of “supply-side economics” back in the
1970s, I think it is long past time that the phrase be put to rest. It did its
job, creating a new consensus among economists on how to look at the national
economy. But today it has become a frequently misleading and meaningless
buzzword that gets in the way of good economic policy.

Today, supply-side economics has become associated with an obsession for
cutting taxes under any and all circumstances. No longer do its advocates in
Congress and elsewhere confine themselves to cutting marginal tax rates — the
tax on each additional dollar earned — as the original supply-siders did.
Rather, they support even the most gimmicky, economically dubious tax cuts with
the same intensity.

The original supply-siders suggested that some tax cuts, under very special
circumstances, might actually raise federal revenues. For example, cutting the
capital gains tax rate might induce an unlocking effect that would cause more
gains to be realized, thus causing more taxes to be paid on such gains even at a
lower rate.

But today it is common to hear tax cutters claim, implausibly, that all tax
cuts raise revenue. Last year, President Bush said, “You cut taxes and the tax
revenues increase.” Senator John McCain told National Review magazine last month
that “tax cuts, starting with Kennedy, as we all know, increase revenues.” Last
week, Steve Forbes endorsed Rudolph Giuliani for the White House, saying, “He’s
seen the results of supply-side economics firsthand — higher revenues from lower
taxes.”

This is a simplification of what supply-side economics was all about, and it
threatens to undermine the enormous gains that have been made in economic theory
and policy over the last 30 years. Perhaps the best way of preventing that from
happening is to kill the phrase “supply-side economics” and give it a decent
burial.

It’s important to remember that at the time supply-side economics came into
being, Keynesian economics dominated macroeconomic thinking and economic policy
in Washington. Among the beliefs held by the Keynesians of that era were these:
budget deficits stimulate economic growth; the means by which the government
raises revenue is essentially irrelevant economically; government spending and
tax cuts affect the economy in exactly the same way through their impact on
aggregate spending; personal savings is bad for economic growth; monetary policy
is impotent; and inflation is caused by low unemployment, among other things.

These beliefs led to many bad economic policies. In particular, they lay at
the root of stagflation, that awful combination of high inflation and slow
growth that bedeviled policy makers in the 1970s. Based on insights derived from
the Nobel-winning economists Robert Mundell, Milton Friedman, James Buchanan and
Friedrich Hayek, the supply-siders developed a new program based on tight money
to stop inflation and cuts in marginal tax rates to stimulate growth.

As the staff economist for Representative Jack Kemp, a Republican of New
York, I helped devise the tax plan he co-sponsored with Senator William Roth, a
Delaware Republican. Kemp-Roth was intended to bring down the top statutory
federal income tax rate to 50 percent from 70 percent and the bottom rate to 10
percent from 14 percent. We modeled this proposal on the Kennedy-Johnson tax cut
of 1964, which lowered the top rate to 70 percent from 91 percent and the bottom
rate to 14 percent from 20 percent.

We believed that our tax plan would stimulate the economy to such a degree
that the federal government would not lose $1 of revenue for every $1 of tax
cut. Studies of the 1964 tax cut showed that about a third of it was recouped,
and we expected similar results. Thus, contrary to common belief, neither Jack
Kemp nor William Roth nor Ronald Reagan ever said that there would be no revenue
loss associated with an across-the-board cut in tax rates. We just thought it
wouldn’t lose as much revenue as predicted by the standard revenue forecasting
models, which were based on Keynesian principles.

Furthermore, our belief that we might get back a third of the revenue loss
was always a long-run proposition. Even the most rabid supply-sider knew we
would lose $1 of revenue for $1 of tax cut in the short term, because it took
time for incentives to work and for people to change their behavior. ...

Moreover, we were adamant that only permanent cuts in marginal tax rates
would stimulate the economy. We thought that temporary tax cuts, tax rebates,
tax credits and such were economically worthless, and we strongly opposed them.

Today, hardly any economist believes what the Keynesians believed in the
1970s and most accept the basic ideas of supply-side economics — that incentives
matter, that high tax rates are bad for growth, and that inflation is
fundamentally a monetary phenomenon. Consequently, there is no longer any
meaningful difference between supply-side economics and mainstream economics.

There is no question in my mind that we never could have overcome the
stagflation of the 1970s as quickly or with as little pain as we did without the
supply-side idea. But supply-side economics has done its job, just as Keynesian
economics did in the 1930s. Those who campaign as its champions are fighting a
fight long won — and it is time for supply-side rhetoric to go, with its
essential truths embodied in mainstream economics and its perversions discarded
for good.

As noted above, I don't fully agree, so let me cast this debate in a
different framework where it's easier for me to highlight where we differ.

Let's start with the following fairly standard picture of the evolution of
GDP. The red line shows actual output cycling over time, and the blue
line shows that natural rate of output which also varies over time:

As depicted, the natural rate is subject to both permanent and temporary
supply shocks causing growth to be uneven, but generally upward, and actual
output is driven away from the natural rate by demand shocks. That is, the
variation in the blue line is from supply-shocks, and the deviation of the red
line from the blue line is from demand shocks.

In general, there are two types of policies to consider. The first is the use of
monetary and fiscal policy to stabilize the economy. The goal here is to use changes in the money
supply, government spending, and taxes to manage aggregate demand and minimize
the deviations of actual output from the natural rate of output. This is shown
by the dotted red line in the following diagram which is closer, on average to
the natural rate than the no-policy outcome shown as the solid red line:

The second type of policy is growth policy. This is what many people mean when they
use the term supply-side policy. The goal here is to increase the growth rate of
output. This is shown by the upward rotation of the trajectory for the natural rate in
the following diagram:

The natural rate of output is determined by the growth of technology, the
growth of the capital stock, and the growth of the labor force so policies to
increase the growth rate of output are directed at these factors. Examples of
supply-side policies are (not all have proven to be equally effective, or
effective at all in some cases, and this is far from exhaustive) tax breaks for research and development (to
increase technology), tax breaks for IRAs (to increase saving, investment, and
the capital stock), tax cuts on capital gains and dividend (to make capital
markets more efficient and increase the capital stock), spending on education
(to make labor more productive), reductions in marginal tax rates (so people
will increase work effort), accelerated depreciation (to make investment cheaper
and increase he capital stock), and reductions in estate taxes (so people will work
harder to leave more for their heirs).

Note also that it is the upward rotation in the supply-curve that generates
the increase in taxes from supply side policies that you often hear about. The
question, of course, is how much additional growth comes from a cut in taxes and
here I agree to some extent with Bruce Bartlett. It depends upon the type of tax
cuts that are enacted, some are more productive than others and hence some types of tax cuts
generate more tax revenue than others. Whether the tax cut is permanent or
temporary is also important.

We'd disagree over the magnitude however.
While some types of tax cuts can affect growth, the effect is nowhere near
large enough to generate a 33% tax revenue recovery rate, not even close, and,
in any case, all the low-hanging fruit has already been plucked, something that
is often overlooked.

That is not the end of our disagreement. Bartlett does not distinguish
between various classes of models, between the short-run and long-run, or
between stabilization and growth policy all of which are important distinctions
so let me touch upon these issues.

There are two predominant views of the source of fluctuations in output, Real
Business Cycle models and New Keynesian models.

Real Business Cycle (RBC) theorists believe that most if not all fluctuations
in the economy are due to supply side shocks, aggregate demand shocks such as
changes in the money supply, changes in taxes, and changes in government
spending affect nominal variables such as prices but have little to do with
changes in output over time (however, government intervention does causes
inefficiencies in these models so that less intervention is generally preferred
to more). Thus, for RBC advocates, the red and blue lines lie nearly on top on
one another because nearly all of the movement in output is due to
supply shocks.

Thus, since short-run demand management is ineffective in these
models (and often counterproductive), all that's left is long-run growth policy and that's why people such as
Bruce Bartlett, who have an RBC model in mind when thinking about policy, tend
to focus on long-run, supply-side, growth enhancing policies.

Let me turn next to Keynesians. My focus is on the New Keynesian (NK) school,
but I should note that I don't agree with all of the characteristics Bartlett
associates with Keynesians of the 1960s and 1970s, and I certainly don't agree
with the claim made in the next paragraph that after the policy failures of the
1970s "the supply-siders developed a new program based on tight money to stop
inflation and cuts in marginal tax rates to stimulate growth." A standard
expectations augmented Phillips curve story does a much better job of explaining
these events, and the interest rate targeting rules used from the early 1980s
onward are not based upon RBC models. Most RBC models don't even include money
as it plays not role in either the short-run or long-run.

New Keynesians (NK) do not deny that shocks to aggregate supply can affect
GDP nor that supply shocks can be large and important. However, New Keynesians
also believe that aggregate demand shocks are important, i.e. that the
difference between the blue and red lines is large.

New Keynesians attempt to stabilize actual output around the natural rate as
shown above. Why does NK policy tend to focus on demand shocks rather than supply shocks? The
answer is that although it would be ideal if we could use supply-side polices to
smooth short-run fluctuations in output arising from supply shocks, the reality is that we cannot
do this.
As Bartlett notes, supply-side polices are very blunt, slow-acting policies that can affect
output in the
long-run, but they are all but useless in dealing with short-run fluctuations in
the economy (thus,
RBC theorists tend to focus mainly long-run growth).

Since supply cannot be managed in the short-run, that leaves demand management policies, i.e. monetary and fiscal policy. As
we learned in the 1970s, demand side tools are not very effective instruments
for offsetting supply-side shocks - trying to use demand side policy to offset supply shocks
helped to generate the stagflation we saw at the time. We've learned since then, but practically we
are still somewhat powerless to offset supply side shocks in the short-run - all
we can do is manage demand to match changes in supply. That is, if a hurricane wipes out supply, we
can use policy to reduce demand to match, but we can't do much to increase
supply back to its initial level in the short-run.

What we can do much more effectively, if you believe in NK models, is stabilize demand shocks through demand management policy. These
policies are relatively simple conceptually, the trick is to manage demand so
that upward and downward demand shocks are offset by appropriate changes in policy, but
that is easier said than done. Still, we do appear to be able to reduce
variation over time through both monetary policy in particular, and also through fiscal policy (e.g. through
automatic stabilizers).

The claim made by Bruce Bartlett that "there is no longer any meaningful difference between
supply-side economics and mainstream economics" is not something I can agree
with. There are big differences between the RBC and NK schools and big
differences in the implications of the two schools for policy in the short-run. RBC advocates do
not believe in short-run stabilization policy, their focus is solely on
maximizing long-run output growth. NK theorists do not deny that robust economic
growth is important, but they also believe that government can play a helpful
role is smoothing short-run economic fluctuations.

Why do Republicans tend to endorse the RBC framework? I believe in many cases
that belief in the RBC model arises from an honest view that the evidence is
most supportive of this class of models. But in other cases I believe it is an
ideological marriage. The RBC model has two features that make it attractive.

First, because it says short-run stabilization policy is ineffective, and
that government intervention through either spending or taxes generates economic
distortions, the RBC framework supports an approach where the role of government
in the economy is minimized.

Second, because the RBC framework allows for tax cuts to produce higher growth by reducing
inefficiencies, and because it is then possible to argue that tax revenues might
increase, it gives two reasons for supporting tax cuts - higher growth and less
than a full loss of tax revenue, i.e. a dollar tax cut does not cost a dollar (or, for serious ideologues, the tax-cuts even
pay for themselves).

The NK model, on the other hand, supports active government intervention
which is at odds with this ideology. In
addition, because the focus in NK models is on stabilization of output around the natural
rate, not on growth of the natural rate, tax-cuts do not
have the dynamic long-run effects as in RBC models (though these can be added)
and hence there is not as much ideological support for tax cuts in the NK framework.

This is much too long already, but a few more things. We don't we know which type of
shock is most important? If demand shocks play a substantial role, we should pay
attention to the NK policy prescriptions, but if aggregate supply shocks are the
primary force behind business cycles, we should abandon short-run stabilization
and focus solely on long-run growth. We don't we just look at the empirical
evidence and figure this out?

The problem, essentially, is that we only have one time-series, GDP, and we
want two things from it, supply shocks and demand shocks. Since we only have one
piece of information and want two things from it, we must make an assumption of
some sort. Under some assumptions, supply shocks appear predominant, but under
others, demand shocks are the most important factor in business cycles. Because
we have no way of knowing for sure which assumption is best, and because the
econometric evidence changes as the assumptions change, we are left with
uncertainty as to which type of shock matters most and hence which model we
ought to prefer.

There is much more to say about all of this, I haven't even mentioned New Classical models, but that will have to do for now. Summarizing, contrary to what is implied in Bruce Bartlett's commentary, there
are two distinct schools in economics, the RBC school and the NK school, and
they have very different policy implications. Not everyone will agree with this, and that is the
point I suppose, but I would argue that the mainstream view today is the NK model, though
the RBC school has strong advocates and has made important contributions to our
thinking (the long-run incentives Bruce Bartlett mentions are a good example).

So, here's where we agree. Both NK and RBC advocates see the long-run
similarly. Both schools agree that demand side polices have little effect on long-run growth. Both agree that incentives matter, and that we should, of course, strive to enhance
efficiency and long-run growth whenever possible. There is a difference in the
two schools as to the strength of those incentives, but if that is all that is
meant by supply-side polices, then fine, no problem, we're in agreement.

But there is a big disagreement over the short-run. RBC adherents take a
hands-off, free market approach. Their model tells them that government
interference causes inefficiencies, and that there is nothing to be gained in
return in terms of enhanced stability. NK adherents believe government
should take an active role in stabilizing the economy and that is something
that, contrary to what is implied above, has not changed since the 1960s and
1970s. The model used by the NK school is very different from the models we used
then - and our approach to policy is similarly different - but the basic idea
that government intervention can help to stabilize output and employment in the
short-run is unaltered.